Venture Capital and the Finance of Innovation

Venture capital funding has long been a source of financing for entrepreneurs, breakthrough technologies, and start-ups. Venture capital backs companies, ideas, and products that carry significant risks and therefore may have difficulty securing more traditional sources of capital backing. Many of the innovative products and services that are supported by venture capital funding have very long development (time to market) cycles and are not appealing to investors seeking more immediate returns on their investment. Venture capital firms use specific and rigorous criteria to evaluate potential funding targets, and few proposed projects are actually able to secure financial backing. Venture capital funding is responsible for financing many innovations in information technology, biotechnology, life sciences, and health care. Venture capital firms seek out radically innovative ideas, what the industry terms disruptive technologies. Information technology, including computer technology and software applications, has been one area where VC funding has enabled the development of many digital age tools and applications. Health care and life sciences remain a favorite area of VC funding and the value of venture capital financing is well documented in the social and economic benefits that have come about through VC backing. Venture capital firms are only able to fund a fraction of the proposals that are made to their firms each year; entrepreneurs, researchers, and institutions are working to secure early financing from venture capital firms and other sources that will help to fund early stage ideas and projects.

Keywords Angel Investors; Bootstrap Funding; Disruptive Technologies; Entrepreneurs; Exit Strategy; Initial Public Offering (IPO); Liquidity Event; Small Business Investment Corporations (SBIC); Venture Capital; Viral Growth

Finance > Venture Capital & the Finance of Innovation

Overview

Venture capital (VC) funding makes an enormous contribution to US jobs, sales, economic growth, innovation, and technological progress. The funding that venture capital provides "nourishes the US economy by bringing innovative concepts and business models to life" ("Venture impact," 2007).

Venture capital financing provides support to innovative and cutting-edge companies in a variety of industry sectors. Some of the industry segments that have benefited the most from VC financing are:

• Computers and Peripherals;
• Retailing and Distribution;
• Software;
• Telecom;
• Biotechnology;
• Financial Services;
• Health Care and Medical Devices.

Venture capital funding is truly unique in its support of entrepreneurial talent. VC funding provides access to "risk capital" that is not typically available from traditional financing sources such as banks. The projects that are particularly interesting to VC firms are quite different that what a bank might see as an ideal financial risk. VC-financed products, firms, and services "threaten" the status quo. VC firms are not looking for ideas that offer a marginal improvement on something that already exists; VC firms are looking for "disruptive technologies" that will provide completely new and innovative products and services. VC firms are also willing to wait for a return on their investment (often five to eight years). Today's more traditional capital markets are looking for much quicker returns, often quarterly, and are not willing to wait years to reap returns on their equity investments.

Another unique contribution that VC firms provide to emerging companies are professional managers who can become actively involved in the growth of the new company. Capital partners from VC firms typically sit on the board of directors of the new company, provide significant input, and also have significant influence in the strategic direction of the new venture. Typically, VC- financed projects are set up as a limited partnership (LP). Investors are limited partners and the firm itself is a general partner. Each unique fund or portfolio becomes a separate partnership.

Venture capital is raised from a number of sources to be invested in various business ventures. Funds are invested in high-growth businesses, and investors anticipate high returns on their investments because of the high risks. There are three general venture capital structures: Traditional venture capital firms (VC), small business interest corporations (SBIC) and angel investors. SBICs are privately owned and operated firms that partner with the federal government to provide venture capital to small businesses. SBICs will lend as little as $50,000 and are likely to offer more flexible terms than traditional VC firms. SBICs provide equity capital, long-term loans, and management assistance to small start-ups that might not be able to get the attention of larger VC firms.

Angel investors provide another type of venture capital (mostly to small businesses). Angel investors are typically single individuals who may be a family member, friend, or mentor of the person who is seeking funding for his or her small start-up. Angel investors are often entrepreneurs who enjoy helping out other small business owners and do so by investing their personal wealth in a start-up business. Angel investors, like all venture capitalists, are seeking high rates of return for their monetary investment, but angel investors are also aware of the high risk that such investment entails.

The third type of venture capitalist is typically associated with a VC firm (traditional VC firm) and will be the subject of this article. Traditional VC firms raise money from private sources that may include hedge funds, pension funds, endowments, insurance companies, foundations, banks, or individual investors. VC firms, on average, fund approximately 10 percent of the deals that their firms consider in a given year (Broome, 2007).

While banks tolerate a low risk/return paradigm, VC firms accept a lot more risk and will often take a 30 to 50 percent ownership stake in the funded company. VC firms also have a significant amount of "strategic involvement" in decision-making in the companies that they fund. Venture capital firms are also focused on an end goal that will culminate in a "liquidity event." A liquidity event is simply an exit strategy that will insure that the investor(s) are paid out completely, most often from the sale of the company through merger and acquisition activity or an initial public offering (Broome, 2007). Venture capital investment is not driven by transaction fees or quick returns. VC funded companies benefit all stakeholders with their success. Investors, employees, and company founders all stand to reap rewards if the VC-financed company is successful in the marketplace. However, it is estimated that 40 percent of VC-backed companies fail, 40 percent return modern amounts of capital, and only 20 percent or less produce high returns; however, these high returns generate most of the capital for VC firms.

Some of the most famous and successful companies in operation today were recipients of venture capital funding early in their development. Examples of companies that got their early funding with venture capital funds are: Microsoft, Intel, and Home Depot, and Medtronic. The economic impact of VC-backed firms is significant in many aspects. Consider the following (National Venture Capital Association, 2013):

• 11.87 million people were employed in jobs created as a result of VC financing in 2010.
• $3.1 trillion in revenue was generated in the United States in 2010.
• VC-financed companies accounted for 11 percent of US private sector Employment in 2010.

Applications

While venture capital investment is becoming a global phenomenon, it is instructive to examine why the United States has always been the most common location for this unique investment option.

The success of the VC model in the United States can be attributed to several factors ("Venture impact," 2007):

• An entrepreneurial spirit which is pervasive in the United States
• Financial recognition of success
• Access to strong science research and institutions.
• Open and fair capital markets
• Protection of intellectual property
• Access to a skilled workforce.

The National Venture Capital Association states that, “Venture capital is quite unique as an institutional investor asset class. When an investment is made in a company, it is an equity investment in a company whose stock is essentially illiquid and worthless until a company matures five to eight years down the road. Follow-on investment provides additional funding as the company grows. These rounds typically occurring every year or two, are also equity investment, with the shares allocated among the investors and management team based on an agreed valuation. But, unless a company is acquired or goes public, there is little actual value. Venture capital is a long-term investment” (“Venture impact,” 2007).

Trends for Venture Capital

In 2010, there were 462 active US VC firms, defined as investing at least $5 million. Venture capitalists invested approximately $22 billion into 2,749 companies (National Venture Capital Association, 2013). Companies developing medical devices and clean technology will likely be the biggest recipients of VC dollars ("Flush with cash-venture," 2007). There is a heightened need for innovative technologies in energy efficiency and medical technology. Along with several "hot" markets, there is a relatively healthy market for initial public offerings (IPO) as well as acquisitions for successful start-ups. The goal of every VC- funded project is to "go public" or become an acquisition target, this is where the real payoff happens. The "healthy exit environment" is spurring investment on the front end for new companies and products as well. Investors know that IPOs and buyouts are the ticket to big payouts and therefore are willing to fill up the pipeline.

Funding a start-up is not an inexpensive proposition; start-up companies need lots of capital to finance their undertakings and establish themselves in the global marketplace. There is a demand for external innovation by large companies as they look beyond their in-house research-and-development functions, which is helping to fuel VC-financed innovation.

General Requirements for VC Funding

According to an Edison Venture Capital spokesperson, their firm sees on average, two thousand proposals a year seeking VC funding. Of those two thousand, approximately three hundred are reviewed by the firm, fifty get serious consideration, and only about eight to twelve receive investment money. These numbers show that it is difficult for start-ups and entrepreneurs to get VC funding. Acquiring VC funding is more than just a numbers game; venture capital firms have very rigorous criteria and requirements before they commit to financing projects. The following benchmarks can serve as a litmus test for a company seeking VC funding (Moyers & Rodman, 2007):

• Venture capital firms love to fund technology projects, especially in such growing fields as clean technology, medical devices, and information technology.
• Venture capital firms do not want to fund companies that could potentially steal market share from established companies. VC funding favors innovation and new products and services.
• VC firms typically do not invest more than $10 to $15 million without a high chance of achieving profitability.
• VC firms are concerned about having clear distribution channels for products. While companies can use established worldwide distribution channels to ship products, VC firms are wary of hidden costs that will reduce profits.
• VC firms shy away from products or services that require intensive customer support functions, as customer or technical support increases the difficulty of orchestrating business operations and eats away at profits.
• VC firms typically want to see gross profits of over 50 percent. Only with this margin are firms confident that general and administrative costs that add to high operating margins will be covered and leave target profits intact.
• VC firms want to fund companies or products that have a high potential of being merged or acquired by another company or of going public (IPO).

Information Technology & VC Funding

Information technology has been the biggest recipient of VC funding in recent years. VC investments in medical devices and equipment have fallen significantly in 2013, despite several years of increases. Investments in medical technology fell $2.14 billion in 2013, down more than 40 percent from 2007 (Walker, 2013). VC funding granted to biotechnology firms declined 28 percent over the same period, while software start-ups received a 75 percent increase in VC funding (Walker, 2013). Today's information technology "darlings" are the so-called Web 2.0 companies. These second generation web start-ups are typically Internet sites that build on the Web 2.0 concepts of communities and collaboration. These companies leverage the concept of social networking and typically concentrate on building a large user-base.

The whole concept of Web 2.0 companies is changing the model for VC funding. Technology has become a commodity and now a "big idea" is paramount. It is cheaper to finance Web 2.0 companies and it is possible for an owner to go a lot further in building value into his or her company before even approaching a VC firm for funding. Owner bootstrap funding is more common in the Web 2.0 model because the whole model is cheaper to initiate.

Web 2.0 companies are much more likely to be acquired than to go public. The trend over the past few years has been for large, established Internet companies with cash to snap up Internet start-ups. A couple of famous examples are Yahoo's acquisition of del.icio.us and Flickr and Google's purchase of YouTube.

Even if a number of Web 2.0 ideas get funded, and that scenario seems likely, there are a number of questions that remain regarding how VC funding might play a role in financing this generation of start-ups. Traditional VC due diligence and assessment techniques do not apply to many of today's start-ups; today the questions that VC firms need to consider are the following:

• How should companies be evaluated when the technology can be so easily replicated?
• How much value does the audience or user-community carry?
• What's the preferred exit strategy?

In the new world of technological innovation, VC firms are likely to change the game plan as they go along in determining risk and potential viability for many new start-ups. The track record of the company's founder is indicative of later successes. Of course, there are still basic evaluation criteria that VC firms will use to consider their prospects, including cash burn, addressable market, competition, and profit potential. Since technology is not a differentiator for Web 2.0 companies, additional factors contributing to growth and success are:

• Viral growth (building an audience through networking);
• Potential for advertising revenue if the site draws lots of visits;
• Transaction revenue—if users purchase goods or services directly from the company.

Those in the industry who follow venture capital markets have taken a wait-and-see approach when it comes to emerging Internet companies. There is no clear agreement on the value of having a solidified business model for new technology companies. Some say that a site can be launched just to see what customers will do before designing a business model. Others involved in VC funding state that business models are always critical and relevant; it is impossible to start a business without having a clear idea about how one will do business, enter markets, and gain a competitive edge ("Flush with cash-venture," 2007). The nature of venture capital firms and their aversion to the status quo of the marketplace assures that venture capital will continue to reinvent itself as new and innovative ideas spring to life. Venture capital funding has contributed to much success in the economy and the marketplace, but VC funding has also contributed to the social well-being of many people. Such is the case with innovation in the life sciences and medical fields, as will be explored in the next section of this article.

Issues

The Life Sciences & VC Funding

Experts agree that virtually the entire biotechnology industry and most of the significant breakthroughs in the medical devices industry would not exist without the support of the venture capital industry.

Emerging life sciences companies are dependent on venture capital investors to grow their businesses. Because their capital needs are so large and their path to market is so long and risky, it is difficult for life sciences start-ups to access bank financing or other traditional sources of capital. For example, it is estimated that the average cost of bringing a new drug to market exceeds $800 million and the entire drug discovery, development, and review process takes, on average, fifteen years to complete ("Key industry facts," 2007).

There is no doubt that many of the most innovative medical breakthroughs have been brought to market with the support of billions in VC funding. Medical innovation financed by VC funding has been a boom to small life sciences companies and affected worldwide markets with many hugely successful therapies and technologies. The challenges to funding medical technology are similar to other VC-funded initiatives. Often, VC funding is the only option; for life sciences and medical innovation there is a high degree of risk, a distinct uncertainty about the outcome of the product or service, and a long road to commercialization of the product. High risk and long time to market are distinctly unappealing to many traditional funding sources.

The track record for venture capital funded innovations in the life sciences and medical innovation is impressive. It is estimated by the National Venture Capital Association that one in three Americans has been positively affected by innovations developed and launched by VC-backed life sciences companies in the last twenty years (Platzer, 2007).

The list of medical innovations that are a direct result of VC funding in the past twenty years is truly impressive. The development of angioplasty technology profoundly affected the medical industry's approach to heart surgery, led to other therapies, and significantly reduced the need to perform open-heart surgery. Ultrasound and fMRI technologies have been developed by VC-financed companies; these technologies have been credited with virtually eliminating the need for exploratory surgery and significantly reducing related expenses. Other VC-funded medical breakthroughs include the development of devices such as the glucose self-monitoring devices for patients with diabetes, implantable defibrillators, and spinal implants. Another highly successful and lucrative suite of medical innovations centers around the development of new drugs. Drugs developed to treat chronic diseases such as cancer, cardiovascular diseases, and diabetes have been credited with improving the health of millions of people while reducing overall medical treatment costs.

Venture capital funds have financed huge numbers of innovative products, therapies, and devices in the life sciences sector. Acquiring VC funding is a real challenge: Estimates are that of one hundred proposals submitted for VC funding, only one will receive backing. For entrepreneurs in the life sciences fields, there are additional challenges to successfully bring a device, drug, or procedure to market; these challenges come in the form of federal regulations. Regulations related to the medical and life sciences industries are unpredictable due to the high risk and time associated with development and testing. Overly restrictive regulations have the potential to add to the already long time to market that is typical in developing life sciences innovations. "Regulatory markets need to remain supportive of and conducive to efficient delivery of medical breakthroughs" (Platzer, 2007).

Academia & the Marketplace

Large venture capital firms are looking for innovative products that are well developed in their life cycle. There is a definite incentive for venture capital to fund small life sciences companies to keep the pipeline full of emerging innovation that can be handed off to larger companies with more resources. One pipeline for innovation (particularly in the field of life sciences research and innovations) is academia. Hospitals, government agencies, and companies are constantly looking for ways to bring medical innovation out of academia and into the marketplace (Rowland, 2007).

Two Harvard-affiliated research hospitals (Massachusetts General Hospital and Brigham and Women's Hospital) established their own venture capital fund (Partners Innovation Fund) to help push inventions out of the lab and into the marketplace (Rowland, 2007). The goal is simple; researchers want to get the technology to market faster and not have potential scientific breakthroughs languish due to a lack of the relatively small amounts of necessary funding. According to the two Boston-based hospitals that are establishing the new VC fund, funding is scarce for small deals, as VC firms tend to focus on larger-scale innovations. The hospitals are certainly not giving up on securing traditional VC funding, but instead are looking for seed money to move their innovations along and make them more attractive to outside investors. In this case, the hospitals are looking to create and fund their own pipeline of innovation. Many really see this trend as collaboration between academia and corporations that will benefit both parties.

As Mark P. Carthy, a general partner at Boston-based venture capital firm Oxford Bioscience Partners, remarked, "In the early '80s, if you had some cancer data on a couple of mice, you could go public. You can't do that any more. Now you need to take it a lot further" (Rowland, 2007). Taking the research further is exactly what Brigham and Women’s and Massachusetts General Hospitals intend to do with their medical innovations. The two hospitals will secure their own VC funding as an effort to develop promising technologies; the hospital researchers will be carrying the balls down the field, getting them ever closer to a handoff to a larger company with the capital resources to take potential breakthroughs all the way to market. If these hospitals are successful, it is almost certain that most or all of the funding will come from venture capital sources.

Terms & Concepts

Angel Investors: Individuals who invest capital in small business. These investors may offer more flexible terms than traditional VC firms but they are looking for high rate of return on investment (ROI).

Bootstrap Funding: The approach taken by some entrepreneurs to avoid using funds from external investors by building equity and value in an enterprise or idea through personal financing and hard work.

Disruptive Technologies: New technology that unexpectedly displaces an established technology.

Entrepreneur: A person who operates a new business or launches a new idea or product and assumes some accountability for the inherent risks.

Exit Strategy: See liquidity event.

Initial Public Offering (IPO): The first time a private company sells stock shares to the public. IPOs are often issued by companies that are looking for more capital to facilitate expansion, but they can also be issued by more established private companies that want to become publicly traded.

Liquidity Event: A general term used to describe a company’s exit strategy. Options include selling the company or issuing an IPO. The intent behind a liquidity event is to turn the company’s founders’ and investors’ ownership equity into usable cash.

Small Business Investment Corporations (SBIC): Private firms that partner with the federal government in providing start-up capital for small businesses. These ventures will lend smaller amounts of money than typical VC firms; in addition to capital, they may also provide loans and management assistance.

Venture Capital: Investments in small start-up companies in either the first seed funding round to help get the company started or in the second growth funding round to help the company to expand. The original investor expects to make money on their original venture capital when the company succeeds.

Viral Growth: High levels of growth (especially related to Internet) that result from individuals passing along information through digital networks. The end result may be large communities of users who share common interests or objectives.

Web 2.0: A second generation of web-based communication based on online communities such as social-networking sites, wikis, and blogs, which aim to promote creativity, collaboration, and sharing between users.

Bibliography

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Suggested Reading

Bulevska, A. (2014). The role of venture capital financing in promoting sustainable development. Journal of Sustainable Development 5(8/9), 91–104. Retrieved November 24, 2014, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=94198756&site=ehost-live

Clark, R. (2007). Brain drain. Entrepreneur, 35(11), 19-20. Retrieved December 7, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=27265111&site=ehost-live

Garretson, C. (2007). Start-ups get VC cash infusion. Network World, 24(42), 24-24. Retrieved December 7, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=27331253&site=ehost-live

Lacy, S. (2007, October 4). Venture capital's hidden calamity. Business Week Online, 25. Retrieved December 7, 2007, from EBSCO Online Database Academic Search Premier. http://search.ebscohost.com/login.aspx?direct=true&db=aph&AN=26934517&site=ehost-live

Mulcahy, D. (2013). 6 myths about venture capitalists. Harvard Business Review, 91(5), 80–83. Retrieved November 26, 2013 from EBSCO online database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=87039868&site=ehost-live